The Next Bank Bailout, And Why It's (Sort of) Different This Time

How paying interest on bank reserves could funnel billions to banks' bottom lines.

There are some words and phrases you should never say when talking about the economy. "Certain," "impossible," and "always," come to mind. The most famous of the unutterables is "This time is different."

But for those wondering why five years of unprecedented money printing hasn't led to runaway inflation, I'd offer that it kind of is different this time. The laws that guide the effects of central bank intervention changed in 2008. It's possible that the new laws will prevent massive money printing from turning into massive inflation. What they will very likely do is set up the next big bank bailout.

Why hasn't several trillion dollars of money printing led to runaway inflation? To conduct quantitative easing, the Fed buys Treasuries and mortgage-backed securities from banks, exchanging newly printed cash for bonds. But rather than lending that new cash out to businesses and consumers, banks have kept it parked at the Fed in the form of excess reserves. The Fed prints money and gives it to banks, and banks effectively hand it right back to the Fed. That's an oversimplification, but it explains why inflation has been tame.

The fear is that banks will increase lending once the economy picks up. That means reserves held at the Fed will fall, and the mountains of cash printed in recent years will flow into the economy, sparking high inflation.

But cognizant of this risk, the Fed lobbied Congress five years ago to let it pay interest on bank reserves. It worked, and in October, 2008, the Fed announced that, for the first time, it will pay banks a set interest rate on reserves they hold at the Fed.

This is hugely important, because it lets the Fed stem a possible drawdown of bank reserves that would push mountains of cash into the economy, igniting inflation. Say a bank has an opportunity to make a loan to a business at an interest rate of 4%. If the bank can alternatively earn a 4% yield keeping cash parked at the Fed, which option do you think it's going to take? At an equal interest rate, any sober banker would choose to keep money at the Fed rather than lend to a business or consumer, since the Fed has no default risk. So, if worried about high inflation, the Fed can raise the interest rate it pays on reserves, shooing banks away from the prospect of flooding the economy with new cash. That hasn't been the case in the past. It really is different this time.

That's the theory, anyway. In practice it will be much messier, if only because paying a high interest rate on reserves will serve as one of the biggest bailouts in banking history. Wells Fargo(NYSE:WFC) and JPMorgan Chase(NYSE:JPM) alone have more than $185 billion parked in reserves at the Fed. Banks currently earn 0.25% on reserves, and industrywide excess reserves (the amount above what is required by law) total $1.5 trillion, generating close to $4 billion a year in risk-free profits. If interest rates return to normal levels, that figure will balloon into a bonanza. James Bullard, president of the St. Louis Fed, told the Financial Times this week (emphasis mine): "If you're going to talk about paying them something of the order of $50 billion -- well that's more than the entire profits of the largest banks."

Will the public put up with that? Will Congress? I don't know, nor does anyone else. Paying interest on reserves is discrete and doesn't require a press release, so the bonanza might go largely unnoticed. And banks have never had a hard time extracting what they want from Washington. But the general consensus is that the public has exactly zero tolerance for more bank bailouts. If the protests are loud enough, the Fed could very well be persuaded to scale back the amount it pays banks for doing nothing. If that's the case, the inflation-fighting potential of paying interest on reserves could be less than is currently envisioned.

Maybe the wisdom is correct -- it's never different this time.

Morgan Housel has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of JPMorgan Chase and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.